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Culture. Commitment. Consistency. Many advisors select exchange-traded funds (ETFs) based on the underlying asset class and fund-specific attributes. But the ETF provider is also important to the long-term success of the investment. When choosing ETFs for your clients, look for a provider who has clearly displayed the culture, commitment, and consistency of a partner worthy of a long-term relationship.

1. What is the provider's history with ETF closures?

In the past two years, a record number of ETFs were closed by their providers. Fund closings tend to be bad news for shareholders, who may walk away with less than the net asset value (NAV) of their shares or who may be stuck with a tax bill for embedded gains.

In lieu of closings, many ETF providers continue to carry funds that are not actively trading in the secondary market and thus have minimal liquidity.

Ask the provider to detail their history of ETF closures. Also, do they currently have any ETFs that are languishing and at risk of closing? These could be red flags for potential investors.

2. How tax efficient are the provider’s ETFs?

Potential tax efficiency is one of the most significant benefits of the ETF structure. Unlike mutual funds, ETFs typically do not have to sell their holdings to meet shareholder redemptions or manage index rebalancing. This can help to minimize capital gains.

Since most passive ETFs track indices, their holdings tend to have less turnover than actively managed mutual funds. This further reduces the need for distributions. But in the world of ETFs, some providers are more committed to tax efficiency than others.

Before selecting an ETF, ask the provider about their track record for distributing capital gains.

3. How liquid are the provider's ETFs?

When an ETF is bought or sold, there is a difference between the highest price a buyer is willing to pay for a share and the lowest price a seller is willing to accept for a share. This is known as the bid-ask spread.
The amount of the spread varies from one ETF to another. While many complex factors drive bid-ask spreads, trading volumes and the size of the fund play a key role. Spreads tend to be greater for ETFs with low trading volumes, such as those that track the performance of niche assets. Larger funds with more liquid underlying assets are more likely to trade with ample liquidity.

To evaluate the liquidity of an ETF, ask the provider:

- How does the fund’s bid-ask spread compare with those of similar funds?
- What is the average daily trade volume of the ETF in dollars?
- How close does the ETF trade to its NAV?

4. What is the provider's product philosophy?

Ask the provider to articulate their product goals and priorities—and be sure their mission aligns with yours. Do they seek to be the low-cost provider? Provide niche exposures? Offer active management via ETFs? Think about what you're looking for on behalf of your clients. You may be willing to pay more for specialized expertise. Or you may want a low-cost core portfolio.

5. How committed to the ETF business is the provider?

The booming popularity of ETFs has led many asset managers to enter the business—some perhaps haphazardly. In 2017 alone, 44 firms launched ETF product lines for the first time.3 Many have rolled out ETFs without a distinct strategy, introduced flashy unproven strategies, or bolted on an ETF capability by purchasing a small provider.

Running a successful ETF product line requires extensive expertise and a commitment of significant resources. Without these, ETFs may fail to thrive, experience poor liquidity, and end up in closure. In all those cases, their investors will pay the consequences.

Ask the provider whether they are devoting the necessary resources to their ETF family. They should be able to point to an experienced portfolio management team, a dedicated capital markets desk, an ETF product management team, and a distinct marketing capability. Before you sign on, find out how long they have managed ETFs and their total ETF assets under management.

6. Does the provider have an established strategic beta product line?

Whether they're called strategic beta, smart beta, factor-based investing, or some other name, ETF strategies that move beyond the market-cap index approach have become wildly popular in recent years. These innovative investment styles may add value and deliver uncorrelated returns to a portfolio, serving as a complement to both market-cap indexing and active management.

In order to meet market demand, more and more providers are rolling out strategic beta products. But these strategies are not all created equal. There are sharp differences between product complexity, fees, the return patterns of the various strategies, and levels of assets under management.

Ask the provider for the track record of their strategic beta funds. Evaluate the size of the funds and their expense ratios relative to other strategic beta ETFs to choose those that best fit your needs.

7. Does the provider profit from securities lending in their ETFs?

Many ETF providers elect to lend securities held by their funds to other market participants such as short sellers. In return, they receive collateral and a loan fee.

Some providers keep a portion of the fee income for themselves. Alternatively, some ETF providers return all of the revenues, net of expenses, from securities lending to the ETF, which may enhance fund returns.

Ask the provider about their securities-lending philosophy and practice, and look for those who take an investor-first approach.

8. How do the provider's expense ratios compare with their peers'?

One of the attractive features that leads advisors to utilize ETFs is the low fees ETFs charge compared with traditional mutual funds.

Comparing providers on the basis of cost is a critical part of the due diligence process. Ask how their expense ratios compare with those of the lowest-cost funds in the same investment categories. Some providers compete on pricing in just a few ETFs but carry higher prices in older funds.

Ask the provider about their pricing philosophy. You'll want to choose a firm with a demonstrated strategy of competitive pricing across their whole ETF product line.

9. How transparent and consistent is the provider?

Transparency is one of the most attractive benefits of an ETF. Many advisors appreciate seeing the underlying holdings of their ETFs in real time. Most—but not all—ETF providers offer daily disclosure of their fund holdings. Does yours? If not, ask why not.

Another important way to distinguish between ETF providers is to evaluate the index providers their ETFs track. Is the index provider high quality, with sufficient brand recognition and depth of resources? Does the ETF provider demonstrate consistency with regard to its index providers and strategies? Or has the firm changed indices or strategies, leaving advisors guessing what could come next?

It pays to take a closer look

Choosing an ETF by looking at the asset class and the specific fund is a good first step. At Charles Schwab Investment Management, we recommend evaluating the provider as well.

There are critical differences in practices and policies across providers—even among the large ETF brands. Asking these nine questions can help you determine whether and how the provider seeks to provide successful outcomes for advisors and their clients.

Ultimately, this due diligence can increase the likelihood of a fruitful long-term relationship between you, your clients, and the ETF provider.

About the author

D.J. Tierney is a Client Portfolio Strategist supporting Charles Schwab Investment Management, Inc. (CSIM). In this role, he represents Schwab ETFs™ to sales channels, clients, and the media. He also works with CSIM’s product team to optimize Schwab's ETF offerings. Mr. Tierney assists in managing relationships and communications for Schwab ETFs with authorized participants, broker-dealers, and regulatory agencies. Prior to joining Schwab in December 2016, Mr. Tierney spent 16 years with Morgan Stanley as a senior institutional sales, trading, and relationship management professional. Mr. Tierney earned a Bachelor of Arts in Economics from the University of California, Los Angeles, and a Master of Business Administration from the University of California Berkeley’s Haas School of Business.

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Investment returns will fluctuate and are subject to market volatility, so an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

The opinions expressed are not intended to serve as investment advice (either under the Investment Advisers Act of 1940 or the Department of Labor’s Fiduciary Advice Rule); a recommendation, offer, or solicitation to buy or sell any securities; or a recommendation regarding specific investment strategies. Information and data provided have been obtained from sources deemed reliable, but are not guaranteed.

Charles Schwab Investment Management, Inc., makes no representation about the accuracy of the information contained herein or its appropriateness for any given situation.

Some of the statements in this document may be forward looking and contain certain risks and uncertainties.

The views expressed are subject to change without notice based on economic, market, and other conditions.

Investors should consider carefully information contained in the prospectus, or if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.